Can I offset the profit of one property with a promissory note due to me in place for expenses on another property? Both homes are equally owned by my partner and I.

[mfarraj94]

Hi All - Happy Wednesday, I had a quick question on how promissory notes work. I own 2 properties in Long Island, NY with a partner and originally decided to split the profit 50/50. Property 1 is for sale, while property 2 is still being worked on - I've decided to exit property 2 since it did not go to plan.

My partner and I agreed on a promissory note that will state I will be paid all profit from prop 1 and also funds from another prop that he solely owns once it sells - what tax implications will I face here. Will I be taxed for the sale of prop 1 even though it offsets my expenses for prop 2? My concern is I don't want to be taxed for prop 1 and then have to chase my partner for more money later on during tax season. All help is appreciated - thank you.

[Opus 17]

You haven't done this yet?  Please hire yourself  professional accountant.

For the most part, a partnership must file a form 1065 tax return, which issues a K-1 statement to each partner reporting that partner's share of income and expenses.  The 1065 is due March 15 instead of April 15, and the minimum late penalty is $195 per month per partner. The K-1 is added to your regular tax return along with other income and expenses.

I believe the partnership can divide the partnership income and expenses in any way that the partnership agrees, although that may depend on state law.  The income from the sale would be reported on the K-1 that you attach to your tax return, so if you agree to take all the responsibility for this transaction, that might be allowable.  However, it can get quite complicated, especially if you also have ongoing expenses and income (is this a rental, or a flip?  Or something else.)

This can be complicated and the consequences for screwing up can be severe, so you really would be strongly advised to get some professional help. 

[mfarraj94]

Thank you very much for your reply, I have not done this yet but looking to hear some general advice before taking any action. 

As you alluded to, I will go ahead and speak with a CPA on this, thank you for all of the information provided. 

[Opus 17]

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@mfarraj94 wrote:

Thank you very much for your reply, I have not done this yet but looking to hear some general advice before taking any action. 

As you alluded to, I will go ahead and speak with a CPA on this, thank you for all of the information provided. 

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Looking at this further, I think what you want is for your partner to buy you out of the partnership,, and the price you have agreed on is the profit from property 1, plus some additional money the partner will obtain on their own (from sale of another property, but since that's outside the partnership, it doesn't really matter where the other partner gets the funds.)

The simplest default method will be for the partnership to sell property 1, report the capital gains as partnership income, and both partners pay half the capital gains tax.  Then, the other partner buys you out.  If the plan is that the other partner won't pay income tax on the property, you would simply make an adjustment in the sales price to offset the taxes that the partner does pay.

I would imagine that you could structure the sale and buyout in a different way where you would pay all the taxes directly, instead of indirectly, but that's where you really want professional help. 

[mfarraj94]

This is exactly what I meant to say, my sincere apologies as I probably was not clear in my initial message. 

The goal here would be to have my partner buy me out of 1 property by using the funds of another property we own together plus the sale of another property he solely owns in case I did not receive all the funds. 

I don't want to get in a situation where the proceeds of stated properities cover my initial expenses but when tax time comes around, I am oligied to pay capital gain tax and end up taking a larger loss. Furthermore, I would then need to chase my partner for the additional funds. Ultimatley, my question here is if I were to restructure my operating agreement that says prop 1 proceeds come to me, prop 2 proceeds go to my partner as he is now the full owner, and execute a promissory note that states these proceeds will cover my initial expense of prop 2 - will I still be taxed? 

[Opus 17]

If the partnership has income, that income, and the tax obligations, are passed on to the partners via the K-1 statement.  Someone has to pay the tax.  

Broadly speaking, if you invested $100,000 in the partnership and you are bought out for $120,000, you have $20,000 of taxable profit.  The entire proceeds are not taxable.  If you were bought out for $90,000, you would have a $10,000 loss, which might or might not be deductible on your regular tax return, depending on the nature of the partnership.

Where are you are running into tricky territory is that you are trying to do two separate things as if they are one thing. Right now, the partnership owns a house.  You want the partnership to sell that house.  By itself, that is a straightforward transaction. The partnership would divide the profits between the partners and the partners each pay the tax on their share.  You also want the other partner to buy out your interest in the partnership.  By itself, this is also fairly straightforward, assuming that the partners can agree on a price.  It gets much trickier when you’re trying to combine those two things in a single transaction.